# P/E Ratio

guys, I know we’ve discussed this before, but I’m still not sure what the resounding opinion is and I also can’t find the relevant thread. So what’s the impact on the P/E ratio when dividend payout increases? thanks.

Lola, ROE X Retention Rate = Growth. When the a company has a low ROE payout should increase because they don’t have profitable opportunities. If ROE is high then payout should decrease. Plug in some numbers and you will tell which way the P/E is moving… D1/(K-G)

I remember denominator dominates in this case. So P/E will decrease. Yes. Probably just use some number to prove it.

the answer is INCREASE the way i remember it is: P = D1/(k-g) now, divide both sides by E1 P/E1 = (D1/E1) / (k-g) so, you can see how the P/E ratio is directly affected by dividend payout ratio (D/E)

I read somewhere that change in g has the greatest impact on P/E, k (rate of return) has the second greatest impact, leaving the numerator (dividend payout) with the least impact (g>k>D). That being said, if the dividend payout increase, the retention rate will decrease, which will then decrease the growth rate. the decrease in growth rate will widen the spread of the denominator which will cause the P/E to decrease.

There is another factor to be considered which was discussed in a couple of threads a few days ago. The actual Increase or decrease is actually defined by the ROE and Ke relationship. If ROE > ke --> Retaining earnings is better than any new project (new equity) that the company might generate. In this case – increasing k (dividend payout) might actually end up reducing the P/E ratio. If ROE < ke --> Then increasing K would increase the P/E ratio.

Dividend payout increases, RR decreases restate g=RR*ROE=(1-Div)ROE where div=dividend payout ratio P/E=Div/(k-(1-Div)(ROE))=Div/(k/Div - roe/div+roe) =1/(1/Div(k-Roe)+Roe) if k>ROE, and Div increases, then denominator smaller, P/E larger if k

hmmmm great points, i’ve honestly never really considered them before… so what happens in the exam? is there a hardset rule about what does what? cos in every prac question that i’ve done, i’ve always assumed increase in dividend payout increases the p/e ratio (im sure) what about if i restate the question… what impact will an INCREASE in dividends have on the PRICE? it will obviously increase it right?

if you increase dividends at the expense of your growth rate (by increasing the payout ratio), then that may not be the case honestly I don’t know and am not inclined to go any further tonight there could be a situation where a judgment call has to be made between what they’re likely asking for from a common sense perspective, vs. what might actually be right from a pure math perspective… I noticed this a couple times in schweser, but am 99% sure CFA has their t’s crossed i’s dotted a lot better, so it’s not something to really worry about in my opinion.

cpk123 Wrote: ------------------------------------------------------- > There is another factor to be considered which was > discussed in a couple of threads a few days ago. > > The actual Increase or decrease is actually > defined by the ROE and Ke relationship. > > If ROE > ke --> Retaining earnings is better than > any new project (new equity) that the company > might generate. In this case – increasing k > (dividend payout) might actually end up reducing > the P/E ratio. > > If ROE < ke --> Then increasing K would increase > the P/E ratio. This is a nice explanation. I remember encountering this prob. in L-I myself.

Agreed cpk’s explanation is the way to go for such questions

Yes. cpk and dimes are right. Nice job. For ROE > k, let k = ROE -c; c > 0. You can reduce the P/E formular to 1/(ROE - c/DPR); where DPR = 1-RR. For ROE < k, let k = ROE+ c; 1/(ROE+c/DPR). For ROE = k, p/e = 1/ROE; stay constand regardless of paymen ratio change.